Sebi could allow mutual funds to ring-fence bad securities

‘Side-pocketing’ would allow funds to carve out defaulting papers to insulate a scheme’s NAV

The Securities and Exchange Board of India may issue a new rule to allow mutual funds to segregate distressed debt securities in their portfolios. The rule, known as side-pocketing, will give fund houses the flexibility to carve out defaulting papers from the rest of the portfolio to ensure the scheme’s net asset value (NAV) remains insulated.

The proposal was recently approved by the mutual fund advisory committee, appointed by Sebi, said two people with direct knowledge of the development. Sebi is expected to make a formal announcement soon, one of the people said.

The move comes in the wake of defaults by IL&FS that led to erosion in NAVs of various debt schemes. The values of some schemes fell 3-6% on a single day — which is about 50-75% of the annual returns of some bond schemes.

In side-pocketing, a mutual fund splits a debt scheme into two portfolios with different NAVs. One is the normal portfolio which is accurate and tradable. The other portfolio includes defaulting securities, and is repaid if and when the money is recovered.

“It essentially freezes the class of investors, so that investors on the date of default are paid. New investors, who come in later, do not get a windfall and undeserved gains,” said Sandeep Parekh, founder of Finsec Law Advisors.

Checks in Place to Curb Misuse“Given the relatively quick insolvency process, investors can expect some payback in a year or two,” said Parekh of Finsec Law Advisors.

The move is aimed at preventing redemption pressure on a fund due to default in a single instrument.

In the past two years, there have been instances of defaults in debt papers of companies such as Amtek Auto and JSPL, which led to massive redemptions in some mutual funds. More recently, the presence of select NBFC papers in various debt portfolios had led to several liquid schemes facing redemption pressure. The decision to introduce side-pocketing has been prompted by recent instances of NAV erosion.

Sebi will put in place sufficient checks and balances to prevent fund houses from misusing the facility, said one of the two people.

Asset management companies will be allowed to carry out a segregation only with the approval of the trustees. It will be allowed solely for papers with a default rating. Fund houses will have to carry out the process in such a manner as to prevent discrimination against any class of investors.

Some members of the mutual fund advisory committee are said to be apprehensive about side-pocketing.

“Side-pocketing also presents a moral hazard. It could encourage people to take unwanted risks because the system ensures the core portfolio is not impacted,” said a senior MF industry official.